The Fed’s Independence

Theorists like to point to the Fed’s independence when it comes to monetary policies; however, one must ask, “Who benefits the most from the Fed’s low interest rate and money printing policies?”  Clearly, U.S. dollar debtors benefit most.  And who is the largest U.S. dollar debtor?  The United States government, of course.

So, the Fed, as the U.S. central bank, plans to keep interest rates low to make it easier for the U.S. government to borrow money cheaply.  It also wants to have a 2% inflation rate to make it easier for the U.S. government to pay off its debts with cheaper dollars.

So where’s the problem?  The problem is that the Fed is walking a tight rope, balancing between deflation and hyper-inflation.  On the deflation hand, we have the crushing debt burden that is stifling the “normal” spending habits of individuals, businesses, and banks.  That’s the debt that was encouraged in the first place by the Fed’s low interest rate policies.  It is also a misallocation of resources relative to market forces, which will ultimately prevail; i.e., interest rates will eventually return to a market rate.  When this occurs, many debtors will default on their debts.  But not the U.S. government.  It will sell its debt instruments to the Fed in return for more U.S. dollars (“monetizing the debt”) until the dollar becomes worthless.

On the hyper-inflation hand, we already have unprecedented levels of money printing (QE) depreciating the value of the U.S. dollar.  We also have the movement, by the Chinese and Russians (among others), to dethrone the U.S. dollar as the world’s reserve currency.  When that happens, the demand for dollars will plummet, along with their value.  The Fed would also have to print more dollars to buy more of the U.S. government debt that the rest of the world no longer wants.

So, what are the chances that the Fed will be able to successfully walk on this tightrope without falling off on one side or the other?  Not good.  Manipulating a $17 trillion economy (not to mention the rest of the world) is more art than science, especially if you subscribe to the wrong science.

The bottom line is that, as long as the Fed continues to do exactly what the U.S. government needs it to do, it can continue to claim its independence.  On the other hand, if it fails to bail out the U.S. Treasury and inflate the currency, the U.S. government will end the charade, and the Fed will lose its appearance of independence.

Robert Jackson Smith

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